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Using a GRAT to Strategically Reduce Estate Tax

A very effective tool in reducing federal Estate Taxes is lifetime gifting. Because large lifetime gifts are added back to a decedent’s taxable estate (generally, all gifts greater than $13,000 in any year to any one recipient), lifetime gifts need to be done strategically to have a real impact on the overall Estate Tax picture. The Estate Tax benefits of lifetime gifting can be leveraged by gifting assets that are expected to appreciate in value, thereby removing the appreciation from the grantor’s taxable estate. Even greater leverage can be utilized by gifting appreciating assets with discounted gift values. A Grantor Retained Annuity Trust (“GRAT”) is an excellent vehicle by which to gain such leverage.

The general idea behind a GRAT is that the grantor gifts a large amount of assets to an irrevocable trust. The trust is required to pay back some portion of the gifted assets (an annuity) to the grantor for a fixed number of years, known as the “GRAT term”. Whatever is left in the irrevocable trust at the end of the GRAT term is excluded from the grantor’s taxable estate (assuming the grantor survives the GRAT term). The mathematical trick that makes GRAT’s so attractive is a time value calculation which allows the grantor to value the gift at a relatively low value for tax purposes.

The GRAT gift is calculated by taking the value of assets originally placed into the trust, less the present value of the annuity payments using a predetermined interest rate set by statute under Internal Revenue Code Section 7520. As of the date of this blog (July 2012), the IRC §7520 interest rate is 1.2%. This relatively low time value of money factor makes the GRAT especially attractive, as the present value of the annuity payments increase, and therefore the value of the gift decreases, as the interest rate drops.

As an example, if the grantor were to put $1,000,000 into a GRAT, with the current IRC §7520 rate, with a retained annuity of approximately $207,000 for 5 years, and an average of 7% appreciation on the assets transferred to the trust, the value of the gift for tax purposes would be nearly $0 while the value of the assets remaining in the trust (which are now outside of the grantor’s taxable estate) is roughly $211,000. The GRAT has essentially removed $211,000 from the grantor’s taxable estate, plus all future appreciation on that $211,000. This was done with virtually no tax consequences to the grantor or the grantor’s heirs.

While this sort of strategy may sound very aggressive and sure to draw attack from the IRS, GRAT’s are one of the rare estate tax minimization techniques specifically sanctioned within the Internal Revenue Code, making the strategy relatively safe from IRS challenge if done properly.

Contact a Penzien & McBride attorney at (586) 690-4400 if you feel you could benefit from a GRAT, or other sophisticated estate tax minimization strategy.